The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Thursday, December 29, 2011

You can have opacity and herd goats or you can have transparency and an industrial economy

In a post on Interfluidity that has received considerable attention in the blogosphere, Steve Waldman asks why is finance so complex. His answer is that complexity is a way to rationalize opacity.

He then goes on and attempts to make the argument for why opacity is good. In doing so, he manages to confirm why opacity needs to be eliminated from the financial system.

Finance has always been complex. More precisely it has always been opaque, and complexity is a means of rationalizing opacity in societies that pretend to transparency.

Actually, finance has not always been opaque. It only tends to have a great deal of opacity during those times preceding financial crises.

Opacity is absolutely essential to modern finance. It is a feature not a bug until we radically change the way we mobilize economic risk-bearing.

Your humble blogger and the economics profession think that opacity is a bug and not a feature. The invisible hand requires transparency and not opacity to work properly.

The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear.

This is a very large assumption.

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened.

And this is a problem why? There are still going to be individuals willing to take risk.

Real enterprise is very risky....

One purpose of a financial system is to ensure that we are, in general, in a high-investment dynamic rather than a low-investment stasis. In the context of an investment boom, individuals can be persuaded to take direct stakes in transparently risky projects. But absent such a boom, risk-averse individuals will rationally abstain. Each project in isolation will be deemed risky and unlikely to succeed. Savers will prefer low risk projects with modest but certain returns, like storing goods and commodities. Even taking stakes in a diversified basket of risky projects will be unattractive, unless an investor believes that many other investors will simultaneously do the same....

If only everyone would invest, there’s a pretty good chance that we’d all be better off, on average our investments would succeed.

Hmmm...pretty much everyone invested in Dutch tulips and they were better off how?

But if an individual invests while the rest of the world does not, the expected outcome is a loss.

That is another major assumption.

There are two equilibria, a good one in the upper left corner where everyone invests and, on average, succeeds, and a bad one in the bottom right where everybody hoards and stays poor. If everyone is pessimistic, we can get stuck in the bad equilibrium. Animal spirits are game theory.

This is a core problem that finance in general and banks in particular have evolved to solve.

A banking system is a superposition of fraud and genius that interposes itself between investors and entrepreneurs. It offers an alternative to risky direct investment and low return hoarding. Banks guarantee all investors a return better than hoarding, and they offer this return unconditionally, with certainty, without regard to whether other investors buy in or not...

Wait a minute, banks are senior secured investors. They are not providers of venture capital.

Bankers make the world a more prosperous place precisely by making promises they may be unable to keep. (They’ll be unable to honor their guarantee if they fail to raise investment in sufficient scale, or if, despite sufficient scale, projects perform more poorly than expected.)...

Like so many good con-men, bankers make themselves believed by persuading each and every investor individually that, although someone might lose if stuff happens, it will be someone else. You’re in on the con.

If something goes wrong, each and every investor is assured, there will be a bagholder, but it won’t be you. Bankers assure us of this in a bunch of different ways. First and foremost, they offer an ironclad, moneyback guarantee. You can have your money back any time you want, on demand. At the first hint of a problem, you’ll be able to get out. They tell that to everyone, without blushing at all.

Second, they point to all the other people standing in front of you to take the hit if anything goes wrong. It will be the bank shareholders, or it will be the government, or bondholders, the “bank holding company”, the “stabilization fund”, whatever. There are so many deep pockets guaranteeing our bank! There will always be someone out there to take the loss. We’re not sure exactly who, but it will not be you! They tell this to everyone as well. Without blushing.

Actually, governments guarantee the deposits. They do not guarantee the bank.

If the trail of tears were truly clear, if it were as obvious as it is in textbooks who takes what losses, banking systems would simply fail in their core task of attracting risk-averse investment to deploy in risky projects. Almost everyone who invests in a major bank believes themselves to be investing in a safe enterprise.

No. Depositors don't make a judgment on whether the bank is a safe enterprise or not. They put their money into the bank because it is guaranteed by the government and therefore perceived to be a safer place to store cash than their mattress.

Even the shareholders who are formally first-in-line for a loss view themselves as considerably protected. The government would never let it happen, right?

The response to the current financial crisis would appear to support this point. However, governments did make shareholders realize losses when they took over the failing savings and loans.

Banks innovate and interconnect, swap and reinsure, guarantee and hedge, precisely so that it is not clear where losses will fall, so that each and every stakeholder of each and every entity can hold an image in their minds of some guarantor or affiliate or patsy who will take a hit before they do.

Look at all that activity that has nothing to do with banks providing funds to entrepreneurs. The point of all this activity is to hide the risk that the bank is taking.

Opacity and interconnectedness among major banks is nothing new. Banks and sovereigns have always mixed it up. When there has not been public deposit insurance there have been private deposit insurers as solid and reliable as our own recent “monolines”. “Shadow banks” are nothing new under the sun, just another way of rearranging the entities and guarantees so that almost nobody believes themselves to be on the hook.

This is the business of banking. Opacity is not something that can be reformed away, because it is essential to banks’ economic function of mobilizing the risk-bearing capacity of people who, if fully informed, wouldn’t bear the risk.

Actually, opacity is not something that is essential to banks' economic function. A government's deposit guarantee is not opaque. Either a bank has the FDIC's permission to say its deposits are guaranteed or it does not.

As for what the bank "invests" in on the asset side of its balance sheet, that too does not require opacity. It is up to the discretion of the bank what it invests in.

What a bank gains from opacity is the ability to hide the true extent of the risks it is taking from investors. As a result, it is highly likely that investors are not fairly compensated for the risk they take and are over-invest in the banks.

Mr. Waldman is right that opacity allows banks to mobilize the risk-bearing capacity of people who, if fully informed, wouldn't bear the risk. This is not a good thing.

Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper. Insufficient economic risks are taken to sustain growth and development. You can have opacity and an industrial economy, or you can have transparency and herd goats.

Actually, the real world appears to suggest that you can have transparency and an industrial economy or you can have opacity and herd goats.

A simple comparison of the Eurozone to Africa would appear to confirm this. In Europe, the banking system tends to be more transparent and we have what I suspect he would refer to as an industrial economy.

A lamentable side effect of opacity, of course, is that it enables a great deal of theft by those placed at the center of the shell game. But surely that is a small price to pay for civilization itself. No?

Actually, civilization does not need opacity and would be better off if the theft made possible by opacity did not occur.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.